In 1776, Adam Smith of Scotland published his masterpiece, The Wealth of nations. It revolutionized economic thinking. In it was the idea that individuals acting in their own self interest, not only promoted their own well being, but by offering their skills and products to those who could use them and profit from them, also promoted the general interests of society. The book was also an attack on mercantilism, the idea that the wealth of a nation was measured by the amount of gold and silver held by its government and its citizens. Instead Smith pushed the idea that a nation's wealth was in the skills of its citizens and its productive capacity. Smith also explained the role of the division of labor and specialization and the trade and increased productivity that this allows. Inherent in all of this was the need for the accumulation of capital as productive capacity.

It took over from feudalism by way of mercantilism. Feudalism was the economic system in which much of the population were serfs attached to the land and worked the land for the profit of land owners. In return, serfs were allowed to live on land and were cared for and offered protection by the land owners.

In the 16th century, the idea that nations became richer and more powerful by trading with other nations so as to accumulate more gold and silver to be held by leading traders and by the state led to a powerful trading class and to the idea that it was through trade that economies became prosperous. Big trading companies became holders of much wealth and became the owners of much productive capital. Capitalism was born.

Keynesianism

As it turns out market capitalist economies, while exhibiting long term trends towards growth, appeared to be prone to booms and busts and by a growing inequality in the distribution of wealth and incomes. The classical economist of the times had developed models of how private markets and capitalism were supposed to work. Nowhere in these models was there any room for extended booms and busts. Say's law, the idea espoused by French economist, Jean-Baptiste Say, that 'supply creates it's own demand,' was the doctrine of the day. Say's law is that the act of creating a product produces an income in wages and profits and rents and interest equal to the price at which the product will be sold (quantity supplied) and thus allows enough income for it to be bought (quantity demanded), so there can never be a prolonged period of insufficient demand or too much supply to cause a glut and unemployment.

In the 1930s British economist John Maynard Keynes began to develop the idea that national market economies can indeed fall into long periods when the aggregate supply of goods produced exceeded the demand for them and the result is unemployment. And more important that there was no effective mechanism by which they would move back to full employment in a timely fashion. Keynes fully developed his ideas in his 1936 book, The General Theory of Employment, Interest and Money. Economics and economic policy has never been the same since.

Monetarism

The ideas of Keynes generated controversy among economist right from the start. In the late 1960s and in the 1970s the ideas of Brooklyn-born and Nobel Prize winning economist Milton Freidman, who taught and practiced his economic teaching and research at the free market oriented economics department of the University of Chicago, challenged Keynesianism as the most accepted doctrine for managing a capitalist economy. Friedman disliked the idea of government trying to keep the economy on an even stable growth path by using government taxing and spending policy. Instead, he advocated the use of the central bank using monetary policy, i.e., controlling the amount of money that is circulating in the economy. In good times, he advocated that the central bank should aim for a steady, stable rise in the amount of money in circulation consistent with the inherent growth rate of an economy's overall output. If the economy should falter, Friedman argued that the remedy was to increase the amount of money in circulation, not to spend or even lower taxes in response.

Supply side economics and the Laffer Curve

In the late 1970s, the Laffer curve, popularized and expounded upon by American economist Arthur Laffer, became a much talked and read about topic. The basic idea was that government taxes hurt the economy and that more taxes hurt more. If you don't tax, you get more economic activity and more product and more growth. Laffer especially emphasized marginal tax rates, the rate of tax that someone pays on her next dollar of income. When it is too high, it can sap incentives and sap the growth out of an economy. The Laffer curve was a graph showing that as tax rates increased from low rates, government total tax revenues would rise, but as tax rates were raised further, the rise in total tax revenue would slow and as tax rates were raised still further, total tax revenue would reach a maximum after which it would begin to fall as tax rates were continuously raised. Laffer thought that in the 1970s, the United States was at or near that maximum where futher rises in tax rates would actually lower overall government tax revenue.

More generally, the ideas expounded by Laffer became included in the idea of supply economics. Supply side economics emphasized that the well being of an economy and its continued growth is best managed by polices that promote growth in productive capacity by using the policies that promote and enhance incentives to work and produce.

His ideas greatly influenced the thinking and economic policies of Ronald Regan, President of the United States.

Share this article

Joseph E. Hight, PhD economics, Brown University. Joe has 30 years of experience as a government and academic economist. While at the U.S. Department of Labor in Washington, DC., he specialized in the evaluation of programs for unemployed workers. He has taught economic courses at George Washington University and the University of Hawaii.